Market Update: Magnificent 7(ish), AI, and Broadening of the Market Rally...

Our last market update was on 11/15/2023—a bit longer between writings than usual. We tend to comment more on the market during times of market stress and stock market corrections (...or bear markets) rather than when things are going smoothly. However, since the time of our last note in mid-November, things have indeed been going quite smoothly! Let’s recap what has happened in the interim.

When we wrote in October and November , we suggested that for the correction to end (remember, markets were in a bit of a free fall from July-October 2023), investors needed to see interest rates and inflation settle down. Notwithstanding a little luck in our timing (!!), both of these came to pass, igniting a very nice year-end rally.

But as we turned the page to 2024, the markets needed a new catalyst to keep the uptrend going. And sure enough, we got one: the rise of Artificial Intelligence (AI). As the baton was passed from the market's reliance on both lower interest rates and lower inflation to AI, stocks began to rally around the incredible enthusiasm for this new technology and what it could mean for corporate profits. And good thing—because as interest rates have ticked higher recently and inflation has proved quite stubborn, the momentum in AI/tech has continued to fuel the market. In fact, as economic numbers continue to be stronger than expected, it is likely that we will have FEWER rate cuts this year than initially anticipated just a few months ago; normally, this type of change in future policy would rattle the markets, but as just mentioned, the excitement of AI is THE story of the markets today. Period.

Of course--as we repeatedly stress, Wall Street always wants us to “worry” about something. Their pitch these days is the concern of "Is the stock market in a new bubble?" (Google searches for the words “stock bubble” are at the highest level since Jan 2022). Let’s put things in perspective. The Nasdaq index only just a few days ago surpassed its high from November 2021. But it took almost 2.5 years to get back to this old high! That’s hardly the definition of a bubble.

Now the average investor may be shocked in this fact because recency bias makes us think that stocks are experiencing some type of "irrational exuberance" (as former Fed Chairman Alan Greenspan described the 1990's tech craze.) But today, the smart investor will remember how far the Nasdaq stocks fell for nearly a full year, between November 2021 through October 2022. Again, the index JUST finally surpassed those levels two and a half years later. Bubbles usually are formed after several years in a row of eye-popping returns. We could argue that tech stocks WERE in a bubble in mid-late 2021, and it was our concern at the time which allowed us to navigate 2022’s bear market fairly well.

But in today's current market, many tech stocks are still nowhere near where they were in late 2021. The difference is the narrowness of leadership in the tech stocks--or what has become known as the "Magnificent Seven." However, even the Mag 7 are losing their luster. Tesla is still lower than it was in late 2021, while Apple, Amazon, and Google are just about flat during that same period. (It is true that Microsoft, Nvidia, and Meta have been clear leaders, and their outsized market capitalization has a significant impact on the general indexes.) Fortunately, we do favor Microsoft and Nvidia as the best positioned companies in AI. But again, these facts probably come as a surprise to most. Are there pockets of overvaluation in the markets? In our opinion, certainly, yes. But these overly-expensive names are still mostly only within the AI/tech sector. Calling the whole market a bubble is a bit hyperbolic. 

Here’s another interesting statistic to consider: Since 1957, if you just bought the 10 largest stocks in the S&P 500 at the start of the year, you underperformed the next 490 stocks by a margin of 2.4% a year. 66 years of this strategy not working! HOWEVER, since 2013, this same strategy has OUTPERFORMED by 4.9% a year. Why? Might be the massive shift in how we invest in the markets. Passive ETF’s and index funds are now the preferred way to invest in the markets, and every single dollar that goes into most of them just keeps buying more of the ten largest stocks. Of course, it could also be related to the long period of zero interest rates during most of this past decade. The truth is we do not know the exact reason, but it is worth considering why these top stocks become bigger and bigger. From a portfolio management standpoint, we will not risk significant exposure in a retiree or soon-to-be retiree client portfolio in such a narrow concentration of stocks....without exception! That would simply be poor risk management! (For clients 10 years or further from retirement, we can take a slightly different view.)

So to summarize our views of the tech sector and/or AI stocks: Although we were more concerned about tech stocks in late 2021 than we are now (mainly because many stocks have still not surpassed their 2021 highs), we ARE tracking the narrowness of the winners and the relatively small pocket of AI stocks which continue to soar.

But enough about tech stocks..... What else are we monitoring? We’ve always stressed market sentiment as an important contrary indicator. In our minds, the long-time negativity amongst strategists and economists was a positive for markets. But it seems that now may be changing; one by one, the calls for recession are being reeled back as strategists now keep raising their market forecasts. What a change from when stocks were going down...Market strategists were tripping over themselves in revising estimates lower!

As an aside, the best example of how this silly game is played was just illustrated with the fall from grace of a well-known Morgan Stanley strategist. This individual had been quite negative on the markets for many years, but as even a broken clock is right twice a day, he built quite a reputation in late 2021 through 2022 as markets tumbled. Morgan Stanley trotted him out to the media every single day, touting his “accurate” forecasts---with the obvious intent of driving new business to their firm. But as every "perma-bear" eventually does, he overstayed his welcome; that is, he stuck to his negative predictions for too long as markets rallied back in 2023 and now early this year.

So, as it happened, just a few weeks ago, on a late Friday afternoon at 4 pm, Morgan Stanley put out a brief press release. This under-the-radar, hoping-no-one-would-see press release announced that this once very popular strategist would no longer be serving as part of Morgan Stanley's Investment Committee. This is how the Wall Street game works, and why we shouldn’t put all our faith in these “predictions” we all read and hear about. Long-term market followers will remember names like Elaine Garzarelli and Meredith Whitney--amongst many others, whose names were used by big Wall Street firms to capitalize on their short-term hits that ultimately proved to be one-hit wonders.

So, in short, what do we make of the current market environment? The increasing positive sentiment and incredible excitement around AI are probably slight negatives for the market as we consider forward-looking returns. However, what can we be constructive about? Credit markets. 2024 has been the best start to a year for these markets EVER; this is a very powerful underlying positive indicator. A RECORD supply of corporate bonds has been issued and the DEMAND for these bonds is outstripping that supply. A very healthy credit market usually is viewed as a positive indicator for the stock market for a couple of reasons. One is that a chunk of this money ends up being used for M&A; a second is that some of the funds can be used to finance stock buybacks ...which usually help support stock prices. And again, another glass-half-full element of the market is that overall valuations for stocks--outside of certain parts of tech-- continue to trade at reasonable valuations.

In closing, we hope this update has given you a broad summary of what has transpired over the last few months in the markets, as well as our perspective in following it. We would love to hear any comments or questions you should have.

Best,

NCM Capital Management

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